Unsystematic Risk: Definition & Examples

In contrast, if a specific tech company experiences management issues leading to plummeting stock prices, it illustrates unsystematic risk. Unsystematic risk, also known as specific or diversifiable risk, plays a crucial role in the field of finance and investment. This type of risk is unique to a particular company or industry, in contrast to market or systematic risk that affects all companies. On the other hand, systematic risk is the risk that affects the entire market or a broad market segment. Common sources of systematic risk include interest rates, inflation, political uncertainty, and widespread natural disasters. Systematic risk is non-diversifiable because such risk factors affect the market as a whole.

In financial jargon, the term “unsystematic” refers to a quality that is not commonly shared among many investment opportunities. This is distinct from systematic risk, the dangers inherent to the market as a whole. This research confirmed earlier advice from Benjamin Graham in his 1949 book, The Intelligent Investor. If you want to know how much systematic risk a particular security, fund, or portfolio has, you can look at its beta, which measures how volatile that investment is compared to the overall market. A beta of greater than one means the investment has more systematic risk (i.e., higher volatility) than the market, while less than one means less systematic risk (i.e., lower volatility) than the market.

Systematic, in this context, refers to the economic, political, and sociological factors that impact all securities to varying degrees. However, systematic risk incorporates interest rate changes, inflation, recessions, and wars, among other major changes. Shifts in these domains can affect the entire market and cannot be mitigated by changing positions within a portfolio of public equities. Systematic risk, also known as undiversifiable risk, volatility risk, or market risk, affects the overall market, not just a particular stock or industry. Because of the far-reaching scope of systematic risk – wherein the entire economy and financial markets are placed in a position of vulnerability – portfolio diversification is incapable of mitigating it.

In the context of an investment portfolio, unsystematic risk can be reduced through diversification—while systematic risk is the risk that’s inherent in the market. Systematic risk is often out of an investor’s control since it’s based on factors like the political and economic environment. To manage systematic risk, investors typically diversify their portfolios by investing in different asset classes. If one part of the market is doing poorly, the other investments can help offset the losses. It is the portion of total risk that is unique to a firm, industry, or property.

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1. For example, a company whose products are more likely to be defective will face more class-action suits than other companies in the same industry.
2. It is also called contingent or unplanned risk or simply uncertainty because it is of unknown likelihood and unknown impact.
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4. Therefore, risk-averse investors should hold well-diversified portfolios.
5. Systematic risk refers to market-wide uncertainties that affect all businesses, while unsystematic risk is industry or company-specific.

Systematic risk is often calculated with beta, which measures the volatility of a stock or portfolio relative to the entire market. Meanwhile, company risk is a bit more difficult to measure or calculate. Used judiciously, these techniques can mitigate the impact of systematic risk.

How diversification helps reduce unsystematic risk

Effectively managing portfolio risk requires addressing both systematic and unsystematic risks. While systematic risk cannot be avoided, investors can hedge these risks through assets like gold, Treasuries, etc. Diversifying across unrelated assets, sectors, geographies, etc. remains key to minimizing exposure to unsystematic risks. A key first step is for advisors to thoroughly assess each client’s risk tolerance based on their investment timeline, income needs, and emotional ability to withstand market volatility. Advisors can then recommend appropriate asset allocations across stocks, bonds, cash, and other securities to align with an investor’s financial goals and comfort with risk. More conservative investors may favor a higher allocation to fixed-income assets, while more aggressive investors may tolerate more equities exposure.

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For example, if an investor has placed too much emphasis on cybersecurity stocks, it is possible to diversify by investing in a range of stocks in other sectors, such as healthcare and infrastructure. The notable characteristic of unsystematic risk is the fact that the risk can be mitigated through portfolio diversification, i.e. the strategic inclusion of uncorrelated assets in a portfolio. Unsystematic risk arises from company or industry-specific factors with a disproportional impact on a specific security (or securities with commonalities). In corporate finance, unsystematic risk is defined as the risk that pertains specifically to individual securities or a particular industry. Examples of systematic risk include economic recessions, inflation, wars, terrorism, natural disasters, and changes in interest rates.

Systematic and unsystematic risks can be mitigated, in part, with risk management. Systematic risk can be reduced with asset allocation, while unsystematic risk can be limited with diversification. In summary, systematic risks unsystematic risk is also known as arise from macroeconomic factors and affect the wider market, while unsystematic risks are unique to individual assets and can be managed through diversification. While diversification works well for unsystematic risk, it has little effect on systematic or market-wide risks like recessions and interest rate changes.

Company-Specific Risks

1. A key first step is for advisors to thoroughly assess each client’s risk tolerance based on their investment timeline, income needs, and emotional ability to withstand market volatility.
2. Imagine a leading smartphone manufacturer facing unsystematic risk due to a major product flaw.
3. Reducing systematic risk can lower portfolio risk; using asset classes whose returns are not highly correlated (e.g., quality bonds, stocks, fixed-rate annuities, etc.).
4. Advisors can then recommend appropriate asset allocations across stocks, bonds, cash, and other securities to align with an investor’s financial goals and comfort with risk.
5. A shortage of silicon chips or lithium could affect the entire technology sector, including Tesla.
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Systematic risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification, only through hedging or by using the correct asset allocation strategy. There are five types of unsystematic risk—business, financial, operational, strategic, and legal/regulatory risk. Systematic risk is risk that is inherent to the entire market or market segment. It is the risk that is not specific to any one company or investment and cannot be diversified away. To manage risk successfully, it’s important to understand the different types of risks that investors face.

For example, if a portfolio is balanced and diversified, and a stock declined because of the company’s bad earnings, the rest of the assets should not be affected by the issues of one specific company. Setting asset allocation ranges rather than fixed targets also provides flexibility to adjust allocations in response to signals about the market cycle. You can broadly categorize unsystematic risk either as business or financial. The preceding bullet points provide an expansion of these two categories. Another potential risk might be Tesla’s CEO, Elon Musk, who has cultivated a reputation as an eccentric and unpredictable genius.

While investors may be able to anticipate some sources of unsystematic risk, it is nearly impossible to be aware of all risks. Unsystematic risk may be significantly reduced through diversification so that systematic risk is all that remains in a portfolio. For a well-diversified portfolio, the unsystematic risk may be negligible. Unsystematic risk can be calculated by subtracting the market risk, or systematic risk, from the total risk.

Systematic risk affects the entire market, while unsystematic risk is specific to a particular company or industry. Both risk types impact investors, but they’re usually managed differently. Investors can reduce unsystematic risk by holding a diversified portfolio instead of investing in individual stocks.